lunedì 20 maggio 2013

Stock market optimism on this scale is hard to explain

Here is a conundrum. Stock markets are rallying. Companies have never been worth so much. Yet the earnings season of the past month or so has revealed little growth in corporate bottom lines, and no growth at all in top-line sales. Why?

Stock market cycles do not move in tandem with either business or economic cycles. The idea is to buy stocks before earnings shoot upwards, not afterwards. So the upward re-rating of the last year or so, as investors have decided to pay more for the earnings streams they are buying, implies optimism about the future, rather than incomprehension of the present.

But optimism on the current scale is hard to explain. Since September 2011, global earnings per share have been flat, while share prices have gained some 30 per cent. Price/earnings multiples have gone from 12 to 16 in the process. Such sharp rises often happen at the beginning of a stock market cycle, after an extreme cycle – but this cycle started much earlier, in March 2009, when sentiment began to recover after the Lehman implosion. Citigroup’s global equity strategist, Rob Buckland, suggests this is the biggest mid-cycle re-rating in 40 years. Can the data emerging from the world’s companies justify such an increase in optimism?

There are huge differences by geography and by sector. Using Bloomberg data on 12-month trailing earnings per share, the divergence between corporate US and the rest of the developed world, particularly Europe, becomes clear. US earnings are rising, and at a record, 16 per cent above their pre-crisis peak from 2007. They are up 120 per cent from their pre-crisis low.

In emerging markets, earnings by this measure peaked in 2011 – above their peak from before the crisis – but are now on a descending trend, down 16.5 per cent from their post-crisis peak. And earnings for the MSCI “EAFE” index – covering the developed markets outside North America – look terrible, down 46 per cent from their pre-crisis peak, and falling steadily. A decade ago, the corporate world was growing more homogeneous, and geographic differences between stock markets were diminishing. No more.

Wherever the corporate US is generating its profits, it is not from revenues, which according to the scorecard kept by Thomson Reuters are exactly flat, up 0.0 per cent from the first quarter of last year.

Admittedly, this is mostly because of lower commodity prices, and spectacularly cheaper fuel thanks to the advent of shale; energy companies’ revenues are down 14.8 per cent over that period, while materials groups’ are down 4.2 per cent. All others at least expect some positive revenue growth. But this is out of kilter with earnings growth of 5.3 per cent over the same period (which includes a small 0.5 per cent increase for energy companies).

In Europe, revenues are worse; down 3 per cent year on year according to UBS. This is no great surprise, given the state of the European economy – but the extent of the damage to top lines does appear to have taken brokers by surprise. Europe had its most disappointing post-crisis earnings season, with the lowest proportion of companies beating their forecasts since 2008. Revenue forecasts for this year have been downgraded for every European sector, except oil.

Earnings forecasts, as gauged by I/B/E/S, do not suggest that these trends will reverse soon. For the US, forecasts for the next 12 months are rising and at a record, up more than 20 per cent from their pre-crisis peak; European earnings are slated for further stagnation, some 40 per cent below their peak before the credit crisis.

So why push up equity multiples in these circumstances? Much has to do with the perceived reduction in “tail risk”. A eurozone disaster seems far less likely now than it did 18 months ago.

But it also has to do with how companies deploy their cash. Margins, already high, are widening further. Low interest rates and a depressed economy enable companies to make higher profits on low sales. It is sensible to call for them to revert to the mean at some point, and it is difficult to see how margins can widen much more from here. But in an era of financial repression, investors are abandoning forecasts of an immediate fall in margins. That leads to pushing up price/earnings multiples.

Companies in Europe have also increased dividends over the past two years, even as sales and earnings have declined. This keeps investors happy when yields on bonds are being kept so low. Not only are they prioritising profits over sales in the present; when it comes to using their cash, they are also prioritising the current wishes of their shareholders, through dividends, over the possibility of capital expenditures to boost growth.

This has helped equities rally in an unusual environment of low yields. It does nothing to boost hopes for economic growth. And after a rally unbacked by profits or sales, equities do not offer great value.